In a previous column, I discussed several high-level themes to review when considering the introduction of responsible or environmental, social and governance–focused funds to a retirement plan lineup. This column drills down more into the process.
There’s a growing number of guides available online to help plan consultants introduce ESG options to plan sponsors and subsequently develop a process for evaluating funds. Here are several worth reading.
Publisher: Defined Contribution Institutional Investment Association (DCIIA)
The contributing authors do a good job providing suggestions on how plan fiduciaries can incorporate sustainable investments into a plan. Among the primary steps:
- Define sustainability and clarify investment beliefs around ESG considerations and incorporate those points into plan documents.
- Understand the differences among ESG-implementation options: material integration across all plan investments; offer sustainable investment funds in the lineup; and offer options through self-directed brokerage.
- Evaluate sustainable investments “in a manner consistent with the assessment of other investment options.”
Publisher: US SIF Foundation
This guide combines a high-level roadmap with more detailed checklists and links to numerous resources on sustainable investing in DC plans. The lists of suggested questions for the different parties involved in the decision, including plan consultants and participants, are a good starting point. Here’s an example from the text with advice for the sponsor:
“In choosing a new fund, your organization may raise the following questions with your retirement committee and/or consultant:
- Will the sustainable fund fill a gap for an asset class not represented in your plan, or will it be an additional option within an existing asset class?
- What is the appropriate asset class, style and vehicle for a sustainable fund in your plan?
- What performance benchmark is appropriate for the additional fund or funds?”
Tracking What Matters
While there are numerous approaches to ESG investing, consultants and sponsors can’t ignore a fund’s expected returns and the risk involved with those returns (i.e., the pecuniary factors). Jon Hale, head of sustainability research for the Americas with Morningstar Inc., notes that advisors should keep in mind that “sustainable funds are first and foremost investments that seek to deliver competitive financial performance.” That perspective will influence the review process, he adds: “Their performance record ought to be judged that way, in the same way [and] in the same context that you evaluate other funds.”
Hale’s advice regarding performance: “I recommend a very straightforward approach of simply comparing the performance of sustainable funds to all the other funds that are trying to apply the same universe in Morningstar terms.” That method has revealed relatively good performance among sustainable funds, he adds. In the broader Morningstar universe, only 10% of funds receive a five-star rating in any given performance period, but Hale’s recent review of sustainable funds found that 21% of the sustainable funds (tracked by Morningstar) received five stars.
Understanding ESG Approaches
Hale explains that funds can choose from a variety of approaches or combined approaches to ESG investing. He identifies six methods, which he summarizes as:
- Applying exclusions
- Limiting ESG risk
- Seeking ESG opportunities through sustainability leaders
- Practicing active ownership
- Targeting sustainability themes
- Assessing impact
(Hale describes these methods in detail in an article on the Morningstar site.
Advisors need to know which method or combination of methods a fund uses, he explains. Otherwise, there is a potential that a mismatch of expectations can occur between the selection of an investment product and the end investor not really understanding what's in the fund.
Venk Reddy is founder and chief investment officer of San Francisco–based Zeo Capital Advisors, which manages several ESG-focused corporate credit portfolios. Reddy operates in the risk-management method Hale describes. ESG factors are risk factors, not short-term performance drivers, Reddy maintains: “They are actually credit factors, [and] a company that's not behaving in a long-term sustainable way is setting the stage for unexpected liabilities down the road. That impacts creditworthiness.”
Reddy offers advice on the factors advisors should consider when evaluating ESG investments for plans. The first step is to understand the investment manager’s process: Are the ESG analytics “native to the process or is just an overlay or a screen,” which research has shown are less effective methods? With that knowledge, the second step is to drill down with the investment manager and ask for examples of their analyses beyond those in the pitch book, Reddy says.
It’s important for consultants performing due diligence to focus on a fund’s underlying ESG approach, Reddy emphasizes. That step will help determine if the fund is delivering a portfolio that aligns with the plan’s desired allocation and investment goals.